Q4 2020 Market Update: The Amoral Market

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There are times when it is discomfiting to be in this business. This is one of them. In a year of misery for millions and constitutional democracy in this country at its most perilous moment since the Civil War, financial markets are in one of the biggest manias in history. In 2020, after the sharpest drop on record early in the year, U.S. stocks soared, while COVID-19 deaths rose even faster. The S&P 500 index rose 16% for the full year, and the NASDAQ composite index (dominated by popular growth companies such as Amazon) rose 43%.

Throughout history, financial manias have recurred, though the stories and companies involved have been different. Most often, companies with exciting new technologies that have the potential to transform society are the most notable. This time, for example, cloud software company Snowflake went public with a market value of $107 billion, although the company has revenues of about $500 million and is expected to be unprofitable through at least 2022. Airbnb went public with a first-day price gain of 113% and a market value of $90 billion, which amounted to more than the market value of the entire publicly traded U.S. lodging industry. Then there’s Tesla, whose stock jumped 743% in 2020. Though Tesla has barely turned a profit, its market value of more than $800 billion exceeds that of Toyota, Honda, VW, BMW, Daimler, GM, and Ford combined.

The decade-long bull market has been led by the dominant technology and social media companies, particularly the FAANGs (Facebook, Amazon, Apple, Netflix, and Google). Momentum-driven hedge funds, often employing advanced trading algorithms, pushed prices higher and higher. Yet the FAANGs peaked early last September and passed the baton to smaller, more speculative stocks bought mainly by individual investors. Retail stock trading hit records, some of which was reportedly with cash from the federal stimulus program. History has shown that retail investors typically buy most aggressively near market peaks.

The tolerance of risk by market participants is heavily influenced by emotional swings between greed and fear. Greed often dominates when economic and profit conditions seem historically strong (which is when stock prices usually peak); fear and market lows occur when conditions are weak. That, of course, was not the case in 2020, when the market surged while the economy was imploding. A combination of fiscal support from Congress (the CARES Act) and aggressive action from the Federal Reserve managed to prop up the financial markets. The Fed has continued to seek to stimulate economic activity through low interest rates on borrowing and through (increasingly extreme) market intervention to boost investor confidence.

Boxed In

The Fed has been caught between a rock and a hard place for years due to the failure of Congress to enact adequate stimulative tax and spending policies since the Great Recession. As a result, the Fed wasn’t able to raise interest rates back to more normal levels when the economy was healthier, which would have provided more tools for addressing the next economic downturn.

With its ultra-low interest rate policy, not only has the Fed driven prudent savers out of deposit accounts and into risky assets such as stocks and high-yield (“junk”) bonds, but it has broken the system for pricing risk in markets. Short-term interest rates are near zero, longer-term rates are between 1% and 2% on government securities, and yields on corporate bonds aren’t much higher, because the Fed has been buying them to keep borrowing costs low for over-indebted corporations. Risk is not being accurately priced for low-quality bonds or emerging market bonds. For example, the government of Peru recently issued bonds that will mature in 100 years with an interest rate of just 3.3%. Would you buy that?

Just as the state of our democracy is unhealthy, the state of financial markets – even the entire global financial system – is unhealthy. The Fed has put itself in a pickle: The debt that the Fed has piled on, in addition to soaring government debt, cannot be repaid through conventional means of higher revenue or lower spending. Our aging population is increasing budget pressures, and a declining share of the population is working, which will make it extremely difficult to reduce the size of the government’s annual deficits, much less shrink the $27 trillion of outstanding debt, which amounts to more than $200,000 for each of the nearly 130 million U.S. households. (When including the unfunded promises to Social Security and Medicare beneficiaries, the debt burden might be four times that size.) With that massive level of debt – plus record amounts of corporate debt – any significant increase in interest rates would cause a crushing increase in interest payments.

The only hope might be Modern Monetary Theory (MMT), which we wrote about recently. MMT is a new twist on an old macroeconomic policy of “priming the pump” of the economy, whereby the federal government increases spending to offset weak demand in the private sector. Unless prices rise sharply (inflation), there is no constraint on printing money to, say, eliminate student loans or send cash to households, such as the $1,200 direct relief payments last year and $600 payments this year. MMT has never been tested until now. But remember, there is no free lunch.

What will the Fed do the next time there is a collapse in market confidence? Some (even new Treasury Secretary nominee Janet Yellen) have intimated that the Fed might buy stocks, as the Japanese central bank has done (though this would require congressional approval). Given the prior actions of the Fed, market participants seem to think that the Fed will do whatever it takes to support the market.

Seeking Out Value

The stock market is more expensive than it has been roughly 99.5% of the time over the past 90 years, as speculation has superseded investing. Speculation implies the hope of being able to sell overpriced assets to a “greater fool” who is willing to pay even more-inflated prices.

Yes, economic fundamentals will surely improve at some point, with pent-up demand spurring a surge in spending for restaurants, entertainment, and travel. As is typical of the stock market, though, stocks of companies in these areas have already risen to reflect those expectations. The inevitable recovery is already “in the price.” (There also has been enormous spending on home offices, exercise equipment, home entertainment, sewing machines, yeast, home improvement, etc., that has already taken place.)

As contrarian value investors, we look for mispricing that produces undervalued stocks, which provides a “margin of safety” for faulty analysis or adverse developments. When bought cheaply enough, such investments tend to have much less to fall than the stocks of widely popular, obviously promising companies where high expectations turn out to be unfulfilled as growth slows.

Where do we find pockets of value? In general, in consumer staples, telecommunications, real estate investment trusts (REITs – particularly health care facilities and industrial warehouses), and health care.

The Fixed-Income Challenge

Turning to fixed-income (bond) investments, conditions here are also unusually challenging. Interest rates on U.S. government securities are between 1.2% and 1.9% for 10- to 30-year maturities, which is not enticing. Given these conditions, we have supplemented our historic practice of buying and holding intermediate-term U.S. government agency securities by adding a government mortgage-backed security exchange-traded fund. This has added a little bit more yield and diversification to our portfolios.

In addition, we favor three unconventional approaches. First, with interest rates so low, the only prospect for significant returns from bonds is from capital appreciation on longer-term bonds if interest rates decline. The bonds could then be sold before maturity if the appreciation were substantial. Second, some of our impact investment vehicles have satisfactory risk-adjusted yields in addition to their nonfinancial returns. Third, common stocks with high dividend yields (backed by solid cash generation) can produce income yields of between 4% and 6%.

In sum, given the current starting point of extremely high stock market valuations and record-low interest rates, we expect returns that are well below long-term averages. No one can forecast the precise levels of the stock market, interest rates, or economic growth. We do, however, spend considerable time assessing what current prices reflect about what others expect, and we look for mispricing opportunities with a conservative approach that we hope provides a margin of safety.

Buckle up. And don’t forget the #1 rule of investing: Don’t lose money. Or, put differently, focus on the return of your capital before return on capital. As Warren Buffett said, “Be fearful when others are greedy, and greedy when others are fearful.”